Cost accounting1

COST ACCOUNTINGMeaning of Cost Accounting and Cost AccountancyIn the initial stages cost accounting was merely considered to be a technique forascertainment of costs of products or services on the basis of historical data. In course oftime due to competitive nature of the market it was realized that ascertainment of cost isnot as important as controlling cost. Hence cost accounting started to be considered moreas a technique for cost control as compared to cost ascertainment.Cost accounting is thus concerned with recording, classifying and summarising costs fordetermination of costs of products or services, planning, controlling and reducing suchcosts and furnishing of information to management for decision making. Cost accounting is the application of costing and cost accountingprinciples, methods and techniques to the science, are and practiceof cost control and ascertainment of profitability.Cost accounting is the process of accounting for costs. It embraces the accountingprocedures relating to recording of all income and expenditure and the preparation ofperiodical statements and reports with the object of ascertaining and controlling costs. Itis mechanism by with costs of products or services are ascertained and controlled.Cost Accounting is the classifying, recording and appropriate allocation of expenditurefor the determination of the costs of products or services, and for the presentation ofsuitably arranged data for purposes of control and guidance of management. It includesthe ascertainment of the cost of every order, job, contract, process, service or unit as maybe appropriate. It deals with the cost of production, selling and distribution. It is thus theprovision of such analysis and classification of expenditure as will enable the total cost ofany particular unit of production or service to be ascertained with reasonable degree ofaccuracy and at the same time disclose exactly how such total cost is constituted (i.e. thevalue of material used, the amount of labour and other expenses incurred) so as to controland reduce its cost. Thus, cost accounting relates to the collection, classification,ascertainment of cost and its accounting and control relating to the various elements ofcost. It establishes budgets and standard costs and actual cost of operations, processes,departments or products and the analysis of variances, profitability and social use offunds.Thus Cost Accounting has the following features:- (a) It is a process of accounting for costs. (b) It records income and expenditure relating to production of goods and services. (c) It provides statistical data on the basis of which future estimates are prepared and quotations are submitted. (d) It is concerned with cost ascertainment and cost control. (e) It establishes budgets and standards so that actual cost may be compared to find out deviations or variances. (f) It involves the preparation of right information to the right person at the right time so that it may be helpful to the management for planning, control and decision making. 1

Cost Accountancy is the application of costing and cost accounting principles, methodsand techniques to the science, art and practice of cost control and the ascertainment ofprofitability. It includes the presentation of information derived therefore for purposes ofmanagerial decision-making. Thus, cost accountancy is the science, art and practice of acost accountant. It is science because it is a body of systematic knowledge having certainprinciples which a cost accountant should possess for proper discharge of hisresponsibilities. It is an art as it requires the ability and skill with which a costaccountant is able to apply the principles of cost accountancy to various managerialproblems. Practice includes the continuous efforts of a cost accountant in the field of costaccountancy. Such efforts also include the presentation of information for the purpose ofmanagerial decision-ma and keeping statistical records.In our discussion however, we would use the terms cost Accounting & costAccountancy almost synonymously Scope of Cost Accountancy The scope of cost accountancy is very wide and includes the following:(i) Cost Ascertainment. It deals with the collection and analysis of expenses, themeasurement of production of the different products at the different stages ofmanufacture and the linking up of production with the expenses. In fact, the varyingprocedures for the collection of expenses give rise to the different systems of costing asHistorical or Actual costs, estimated costs, Standard costs etc. Again the varyingprocedures for the measurement of production have resulted in different methods ofcosting such as Specific Order Costing, Operation Costing etc. For linking up -ofproduction with the expenses the different techniques of costing such as marginal costtechnique, the total cost technique, direct cost technique etc. have been evolved. All thethree i.e. systems, methods and techniques can be used in one concern simultaneously.(ii) Cost Accounting. It is the process of accounting for cost which begins with recordingof expenditure and ends with the preparation of statistical data. It is formal mechanismby means of which costs of products or services are ascertained and controlled. Cost canbe ascertained either by following the historical or predetermined system of costing. Costcan be predetermined either by standard costing or estimated costing. If the cost andfinancial accounts are kept separately then their reconciliation is also to be done in orderto verify the accuracy of both sets of accounts.(iii) Cost Control. Cost Control is the guidance and regulation by executive action of thecosts of operating an undertaking. It aims at guiding the actual towards the line oftargets; regulates the actuals if they deviate or vary from the targets; this guidance andregulation is done by an executive action. The cost can be controlled by standard costing,budgetary control, proper presentation and reporting of cost data and cost audit.Objectives of Cost Accounting The objectives of cost accounting are ascertainment of cost, fixation of selling price,proper recording and presentation of cost data to the management for measuringefficiency and for cost control. The aim is to know the methods by which expenditure onmaterials, wages and overhead is recorded, classified and allocated so that the cost ofproducts and services may be accurately ascertained; these costs may be related to salesand profitability may be determined. Yet with the development of business and industry,its objectives are changing day by day. The following are the main objectives of costaccounting: (a) To ascertain the cost per unit of the different products manufactured by a business concern. 2

(b) To provide a correct analysis of cost both by process or operations and by different elements of cost. (c) To disclose sources of wastage whether of material, time or expense or in the use of machinery, equipment and tools and to prepare such reports which may be necessary to control such wastage. (d) To provide requisite data and serve as a guide to price fixing of products manufactured or services rendered. (e) To ascertain the profitability of each of the products and advise the management as to how these profits can be maximized. (f) To exercise effective control of stocks of raw materials, work-in-progress, consumable stores and finished goods in order to minimize the capital locked up in these stocks. (g) To reveal sources of economy by installing and implementing a system of cost control for materials, labour and overheads. (h) To advise management on future expansion policies and proposed capital projects. (i) To present and interpret data for management planning, decision-making and control. (j) To help in the preparation of budgets and implementation of budgetary control. (k) To organize an effective information system so that different levels of management may get the required information at the right time in right form for carrying out their individual responsibilities in an efficient manner. (l) To guide management in the formulation and implementation of incentive bonus plans based on productivity and cost savings. (m) To supply useful data to the management to take various financial decisions such as introduction of new products, replacement of labour by machine etc. (n) To help in supervising the working of punched card accounting or data processing through computers. (o) To organize the internal audit systems to ensure effective working of different departments. (p) To organize cost reduction programmes with the help of different departmental managers. (q) To provide specialized services of cost audit in order to prevent the errors and frauds and to facilitate prompt and reliable information to the management. (r) To find out costing profit or loss by identifying with revenues the costs of those products or services by selling which the revenues have resulted.Broadly speaking, the above objectives can be re-grouped under the following threeheads: (a) Ascertainment and analysis of cost and income by product, function andresponsibility. (b) Accumulation and utilisation of cost data for control purposes to have the minimum possible cost consistent with maintenance of quality. This objective is achieved through fixation of targets, ascertainment of actuals, comparison of actuals with targets, analysis of reasons of deviations between actuals and targets and reporting deviations to the management for taking corrective action. (c) Providing useful data to the management for taking decisions.Advantages of Cost AccountingThe main advantages of cost accounting are given below(i) Profitable and unprofitable activities are disclosed and steps can be taken to eliminateor reduce those activities from which little or no benefit is obtained or to change themethod of production in order to make such activities more profitable. 3

(ii) It enables a concern to measure the efficiency and then to maintain and improve it.This is done with the help of valuable data made available for the purpose of comparison.For example, if material spent upon a pair of shoes in 1996 comes to Rs. 160 and for asimilar pair of shoes the amount is Rs. 165 in 1997, the increase may be due to increasein prices of material or more wastage in the use of materials or inefficiency at the time ofbuying or unnecessarily high prices paid.(iii) It provides information upon which estimates and tenders are based. In case of bigcontracts or jobs, quotations cannot be given unless the cost of completing the contractscan be found out.(iv) It guides future production policies. It explains the cost incurred and profit made invarious lines of business and processes and thereby provides data on the basis of whichproduction can be appropriately planned.(v) It helps in increasing profits by disclosing the sources of loss or waste and bysuggesting such controls so that wastages, leakages and inefficiencies of all departmentsmay be detected and prevented.(vi) It enables a periodical determination of profits or losses without resort tostocktaking.(vii) It furnishes reliable data for comparing costs in different periods, for differentvolumes of output, in different departments and processes and in different establishments.This helps in maintaining costs at the lowest point consistent with the most efficientoperating conditions.(viii) The exact cause of a decrease or an increase in profit or loss can be detected. Aconcern may suffer not because the cost of production is high or prices are low but alsobecause the output is much below the capacity of the concern. This fact is revealed bythe cost accounts only.(ix) Cost Accounting discloses the relative efficiencies of different workers and therebyfacilitates the introduction of suitable plans of wage payment to reward efficiency and toprovide adequate incentive to the less efficient workers. A good system of costingpromotes prosperity of the business and thus ensures greater security of service andadequate reward to workers.(x) It enables the creditors and investors to judge the financial strength andcreditworthiness of the business. A sound business concern with a good system ofcosting can attract more investors than a similar concern without an adequate system ofcosting.(xi) Helpful to the Government. It facilitates the assessment of Excise Duty and IncomeTax and the formulation of policies regarding industry, export, import, taxation etc. Italso facilitates the preparation of national plans for economic development. It providesready figures for use by the Government for application to problems like price fixation,price control, tariff protection, wage level fixation, payment of dividends or settlement ofdisputes.(xii) Helpful to Consumers. The ultimate aim of costing is to reduce cost of production tothe minimum and maximise the profits of the business. A part of the benefit resultingfrom the reduction of the cost is usually passed on to the consumers in the form of lowerprices. Besides, the installation of a costing system will infuse confidence in the minds ofthe public about the fairness of the prices charged.(xiii) Efficiency of Public Enterprises. Costing has a more important role to play inpublic enterprises than in private enterprises. In public enterprises, primary objective isnot to raise profit but it is to serve the society by providing quality goods at cheaper rates.Therefore, whatever limited information theP usual profit and loss account can give incase of a private enterprise, is not available in case of a public enterprise. The efficiency 4

of a public sector can, therefore, be best judged by comparing its cost of production withthe cost of production of its counterpart in the private sector. Public enterprises lack thepersonal initiative and interest of private enterprises. A good system of costing ensuresefficient and effective control through a proper analysis of their working. It provides forgraded financial control over expenditure and avoids conflict of authority. It measuresefficiency and profitability of the undertaking to justify its running in the public sector. Ithelps the management in fixing a reasonable selling price for the products manufacturedor services rendered.Costing-An Aid to ManagementPlanning; decision-making and control are three important functions of the management.It is desirable to have a brief discussion of these functions.Planning - Planning is thinking in advance i.e. looking ahead and deciding in advancewhat to do, how to do it, when to do it and who is to do it. In planning, the managementis concerned with laying down objectives and determining the courses of actions to befollowed out of the several alternatives available to achieve those objectives. Thus,planning is concerned with future activity and formulates budgets to meet the objectivesof the organization.Decision Making - Since management has to make a choice of one course of action outof the several alternative courses of action available, it involves decision-making. Allrational decisions are based on accounting information. Decisions may relate to variousproblems like (i) Fixation of price; (ii) Whether or not price should be reduced forincreased level of sales; (iii) Whether a change in production should be followed; (iv)Whether or not factory should operate at full capacity; (v) Determination of the mostprofitable levels of production ; (vi) Whether to make or buy a spare part ; (vii) Whethera new product should be introduced in the market ; (viii) Whether the product should beexported or not ; (ix) Whether a particular market should be tapped or not ; (x) Whether aproduct should be discontinued to avoid the present loss ; and (xi) Whether or not aninvestment in a particular asset will be worth while.Controlling - Controlling is that part of the management activity whereby managerscompare actual performance against the planned performance, find out the deviations andtake remedial steps to remove the deviations. Immediate action should be taken toremove the deviations to make an improvement in the performance because promptnessis the essence of an effective control. Thus, control helps correction. Planning andcontrolling are interlinked with each other because a manager cannot control unless hehas planned a course of action.The above functions of management cannot be satisfactorily carried out by financialaccounting because of its limitations. Cost accounting is very helpful in performing thefunctions of planning, decision-making and controlling effectively.Cost accounting helps the management in carrying out efficiently its functions (i.e.planning, budgeting, decision-making, organizing, control, pricing and evaluation ofoperating efficiency) by developing practical cost procedures that provide informationuseful in controlling the operations of the business enterprise. Cost accounting does thisby analyzing, recording, standardizing, forecasting, comparing, reporting andrecommending. Cost accounting methods supply the basis of factual information onwhich management can build up its presentation of planning and control. In fact, costaccounting is so closely allied to the management that it is difficult to indicate wherework of the cost accountant ends and managerial control begins. To quote Blocker andWeltmer, "In general, it may be said that cost accounting is to serve management in the 5

execution of policies and in the comparison of actual and estimated results in order thatthe value of each policy be appraised and changed to meet future conditions."A good system of cost accounting serves the management in the following ways(a) Classification and Sub-divisions of Costs. Costs are collected and classified byvarious ways in order to provide information to the management for control purposes andto ascertain the profitability of each area of activity. It enables a concern to measure theefficiency, and then to maintain and improve it. Unprofitable activities are disclosed andsteps can be taken to make an improvement in those activities.(b) Control of Materials, Labour and Overhead Costs. An efficient check is providedon stores and materials. Stores Ledger and Material Abstracts are maintained whichprovide an effective check on the stores and material used in a business. By adopting themaximum limit for stores the total capital outlay is controlled and total financial loss dueto over-stocking is obviated. Information of stock of various materials and stores isconstantly available. This helps in planning the production according to availability ofmaterials and fresh stocks can be arranged in time. Loss due to carelessness or pilferageor any other mischief is detected and steps may, therefore, be taken to minimize such lossin future. An efficient check on labour and machines is provided by giving detailedinformation about the availability of machine and labour capacity. The work is soplanned that no section is over-worked and no section remains idle. The maintenance oftime and job cards for workers discloses the loss incurred by idle time and indicates thedirections in which losses may be minimized. The relative advantages of remuneratinglabour on the time or piece work or premium plans may be ascertained. It also measuresthe efficiency of the wage system in use. Cost Accounting thus provides a detailedcontrol of materials and stores and labour costs. Various techniques of materials controlare applied in order to avoid the excessive locking up of capital in stock of materials andstores. Idle time should be kept as low as possible. By having proper classification ofoverheads into controllable and uncontrollable or fixed and variable, it helps to controlthe overhead costs.(c) Business Policies. Business Policy may require the consideration of alternativemethods and procedures and this is facilitated by cost information correctly presented.For example, by the aid of cost reports management can decide whether the manufactureof certain products increases overhead expenditure disproportionately or whether to treatbyproducts even at a loss to make possible a more important trade in another product.Thus, it helps the management to take vital decisions such as introduction of a newproduct, selection of a most profitable product mix, utilization of spare capacity,exploration of additional market, whether to make or buy, problem of limiting factor,replacement of existing assets, appraisal of proposed investment to meet expansionprogrammed etc. with the help of marginal costing techniques and differential costanalysis.(d) Budgeting. It provides the use of budgets and performance reports and enables themanagement to correct inefficiencies before they enter into business. It is a coordinatedplan of action for every responsible person for comparing the actual results with thebudgets. Two important cost accounting tools for helping managers are budgets andperformance reports. Budgets are financial and/or quantitative statements prepared andapproved prior to a defined period of time, of the policies to be pursued during thatperiod for the purpose of attaining objectives of the management. Thus, budgets are the 6

formal quantifications of the plans of the management. Performance reports measureactual performance and give accounts of comparisons of budgets with actual resultswhich facilitate action against those persons whose performance is less than theperformance specified in the budgets. The technique of control through performancereports is technically known as management by exception, which is the practice ofconcentrating on areas whose performance is not unto the mark as it was planned andignoring areas that are running smoothly as these were planned.(e) Standards for Measuring Efficiency. It provides the use of standards to assistmanagement in making estimates and plans for future and to provide the basis ofmanagement of efficiency. Actual are compared with predetermined standards todetermine the operating efficiency.(f) Best Use of Limited Resources. In all varied fields we are concerned to make thebest use of limited resources that are available to us. Thus the intention is to obtain themaximum output from a given input. Cost Accounting provides the reliable data of costswith regard to materials, wages and other expenses. These help management to getmaximum output at the minimum cost by indicating where economies may be affected,waste eliminated and efficiency increased; some of the loss occasioned by reducedturnover and falling prices may be avoided.(g) Instrument of Management Control. It provides management with valuable datafor planning, budgeting and control of costs. The Organization and management ofundertaking must be planned and controlled in such a way that the desired volume ofproduction is achieved at the least possible cost in relation to the scheduled quantity ofthe product. The measurement of the degree to which this objective is attained, isprovided by cost accounting. An efficient system of cost accounting is, thus, regarding asan important part in the efforts of any management to secure business stability.(h) Cost Audit. The operation of a system of cost audit in the Organization will assist inprevention of errors and frauds. It will help to improve cost accounting methods andtechniques to facilitate prompt and reliable information to the management.(i) Special Factors. It informs the management about the special factors such asoptimum profitability, seasonal variations in volume and costs, idle time of labour andidle capacity of the machine etc. It also helps to curtail the losses during the off season.(j) Price Determination. It helps the management to fix the remunerative selling pricesof various items of goods in different circumstances. During the period of depression abusinessman has to become very watchful and vigilant in tracking down the concealedinefficiencies and sources of wastage, so that he may reduce the cost of production to theminimum. He has to resort to price cutting to such an extent so as to recover variablecosts. Cost Accounting makes a distinction between fixed and variable costs and helpsthe businessman in the determination of prices in the depression period. The fixation ofprices cannot be properly done unless proper figures of cost are available. If prices arefixed without costing information, it is possible, that prices quoted may be too high or toolow. In periods of depression, it may become necessary to reduce the prices even belowtotal cost. It is only costing which will guide the businessman in this matter. 7

(k) Expansion. Management is able to formulate expansion policy on the basis ofestimates of cost of production at various levels provided by the cost accountant.Financial Accounting vs. Cost AccountingThe main differences between financial and cost accounting are given as under: Point of Financial Accounting Cost Accounting Distinction 1 . Purpose It provides information about the It provides information to the business in a general way. It tells management for proper about the profit and financial planning, operation, control position of the business to and decision-making. owners and other outside parties. 2. Form of These accounts are kept in such a These accounts are generally accounts way as to meet the requirements kept voluntarily to meet the of Companies Act and Income requirements of the Tax Act. management. But now Companies Act has made it obligatory to keep cost records in some manufacturing industries. 3. Recording It classifies, records and analyses It records the expenditure in an the transactions in a subjective objective manner ie. according manner i.e. according to the to the purposes for which the nature of expenses. costs are incurred. 4. Control It lays emphasis on the recording It provides a detailed system of aspect without attaching any control for materials, labour importance to control. and overhead costs with the help of standard costing and budgetary control. 5. Periodicity of It reports operating results and It gives information through reporting financial position usually at the cost reports to management as end of the year. and when desired. 6. Analysis of Financial accounts are the Cost Accounting is only a part profit accounts of the whole business. of the financial accounts and They are independent in nature discloses profit or loss of each and disclose the net profit or loss product, job or service. of the business as a whole. 7. Reporting of The costs are reported in The costs are broken down on costs aggregate in financial accounts. a unit basis in cost accounts. 8. Nature of Financial accounts relate to Cost Accounts relate to transactions commercial transactions of the transactions connected with business and include all expenses the manufacture of goods and viz., manufacturing, office, services and include only those selling and distribution etc. expenses which enter into the Financial accounts are concerned production. Cost Accounts are with external transactions i.e. concerned with internal transactions between the business transactions which do not form 8

concern on one side and third the basis of payment or receipt parties on the other. These of cash. transactions form the basis for payment or receipt of cash.9. Information Monetary information is only Non-monetary information used (i.e. only monetary like units is also used (i.e. it transactions are recorded). deals with monetary as well as non-monetary information).10. Fixation of Financial accounts are not Cost accounting providesselling Price maintained with the object of sufficient data for fixation of fixing selling prices. selling prices.11. Figures Financial accounts deal mainly Cost Accounts deal partly with with actual facts and figures. facts and figures and partly with estimates.12. Reference In devising or operating a system No such reference is possible. of financial accounting reference Guidance can be had only can be made in case of difficulty from a body of conventions to the company law, case followed by cost accountants. decisions and to the canons of sound professional practice.13. Relative Financial accounts do not Cost accounts provide valuableefficiency provide information on the information on the relative relative efficiencies of various efficiencies of various plants workers, plants and machinery. and machinery.1 4. Stock Stocks are valued at cost or Stocks are valued at cost.valuation market price whichever is less.15. Type of science Financial accounting is a positive Cost accounting is not only a science because it is subject to positive science but also a legal rigidity with regard to the normative science because it preparation of the financial includes techniques of statements. budgetary control and standard costing. Costing is an empirical science, that is to science, the rules which govern it are largely conditioned by the operations, personnel and policy of the undertaking with respect to which is its techniques are to be applied. 9

Limitations of Cost AccountingCost accounting like other branches of accountancy is not an exact science but is an artwhich has developed through theories and accounting practice based on reasoning andcommon sense. Many theories can be proved or disproved in the light of conventions andbasic principles of cost accounting. These principles are not static but changing with thechange of time and circumstances. The following are the main limitations of costaccounting:(i) Cost accounting lacks a uniform procedure. It is possible that two equally competentcost accountants may arrive at different results from the same information. Keeping inview this limitation, all cost accounting results can be taken as mere estimates.(ii) There are a large number of conventions, estimates and flexible factors such asclassification of cost into its elements, issue of materials on average or standard price,apportionment of overhead expenses, arbitrary allocation of joint costs, division ofoverheads into fixed and variable costs, division of costs into normal and abnormal andcontrollable and non-controllable and adoption of marginal and standard costs due towhich it becomes difficult to have exact costs. Moreover, no one cost is suitable for allpurposes and under all circumstances. Virtually its calculation depends on the use towhich the data are required to be put to. Because of inclusion of some items of cost onestimated basis it is difficult to have actual true cost. On this basis when the valuation ofstock is done, that will not be based on true facts and naturally the profit calculated fromthe cost records will not be true.(iii) For getting the benefits of cost accounting many formalities are to be observed by asmall and medium size concern due to Which the establishment and running costs are somuch that it becomes difficult for these concerns to afford its cost. Thus cost accountingcan be used only by big concerns.(iv) The contribution of cost accounting for handling futuristic situations has not beenmuch. For example, it has not evolved so far any tool for handling inflationary situation.Objections against Cost AccountingA number of objections are generally raised against the introduction of costing on variousgrounds. The following are some of the important objections usually raised1. Want of necessity. It has been argued that costing is of recent origin and that industriesprospered in the past and are still prospering without the aid of costing and, therefore,expenditure incurred in installing a costing system would be an unnecessary expenditure.This argument overlooks the fact that modern industries are running under highlycompetitive conditions and that every manufacturer should know the actual cost ofproduction to decide how far he can reduce the selling price. Many industrial failures inthe past may be attributed to the lack of knowledge on the part of manufacturer of actualcost of production and, therefore, selling products below cost.2. Inapplicability. It is argued that modern methods of costing are inapplicable to manytypes of industries. It is true that costing cannot be applied with advantage to tradingconcerns and concerns of small size. But in many cases some methods of costing canalways be devised to suit the requirements of the business. It should be clearlyunderstood that there is no stereotyped system of costing which can be applied to alltypes of industries. The system of costing should be so devised as to suit the business butnot the business to suit the system. .3. Failure in many cases. It is argued that the adoption of costing system failed toproduce the desired results in many cases and, therefore, the system is defective. The 10

failure of a system may be due to several causes such as apathy or indifference of themanagement, lack of adequate facilities, non-co-operation or opposition from theemployees. So it is hasty to find fault with the system, if it fails to produce the desiredresults.4. Mere matter of forms and rulings. It is argued that after some time, a costing systemdegenerates into a matter of forms and rulings. This is not the fault of the system. It isthe fault of the way in which the system is maintained. Forms and rulings are essentialfor a costing system but they must be revised and brought up-to-date in the light ofaltered conditions. If this is not done, the system is bound to degenerate into a merematter of forms and rulings.5. Expensive. It is said that the cost involved in installing and working a cost system isout of all proportions to the benefits derived therefrom. It may be stated in thisconnection that a costing system must be a profitable investment and should producebenefits commensurate with the expenditure incurred on the system. If care is taken todevise a costing system to suit the requirements of the industry and avoid unnecessaryelaboration, expenditure incurred in installing and operating the system will be aprofitable investment and will bring adequate return.General Principles of Cost AccountingThe following are the main principles of Cost Accounting:1. Cause-effect relationship. Cause-effect relationship should be established for each itemof cost. Each item of cost should be related to its cause as minutely as possible and theeffect of the same on the various departments should be ascertained. This cost should beshared only by those units which pass through the departments for which such cost hasbeen incurred. 2. Charge of cost only after its incurrence. Unit cost should include only those costswhich have been actually incurred. For example unit cost should not be charged withselling cost while it is still in factory.3. Cost accounting should ignore the convention of prudence. Cost accounting statementsshould give the factual picture of the profitability of the project. If some contingenciesneed to be made, it should be shown distinctly and separately.4. Past cost should not form part of future costs. Past cost (which could not be recoveredin past) should not be recovered from future cost as it will not only affect the true resultsof future period but will also distort other statements.5. Exclusion of abnormal costs from cost accounts. All costs incurred because ofabnormal reasons (like theft, negligence) should not be taken into consideration whilecomputing the unit cost. If done so, it will distort the cost figures and mislead themanagement resulting in wrong decisions.6. Principle of double entry should be followed preferably. To lessen the chances of anymistake or error, cost ledgers and cost control accounts, as far as possible, should bemaintained on double entry principles. This will ensure the correctness of cost sheets andcost statements which are prepared for cost ascertainment and cost control. 11

METHODS OF COSTING: Different methods of cost finding are used because business vary in their nature and inthe type of products or services they produce. The output has to be costed, so that costingmethods to be employed are also determined with due regard to the method of productionand the unit of cost used. 1. Job costing :This method is applied where the items of prime cost are traceable to specific jobs or orders, as in house building, ship building engine and machinery construction and repair, contractors work e.g. making reinforced concrete structures, garage and repair shops, foundries and general engineering workshops. Here each job is separately identified and prime cost and overhead is charged to it. Job costing may include the following terms : a. Contract costing – In building trade, a contract is treated as a whole job and is costed in total. Contract costing is used where the job is big and spread over long periods of time. b. Terminal costing – This method emphasizes the essential nature of job costing, i.e. the cost can be properly terminated at some point and related to a particular job. c. Departmental costing – If the output of or service performed by a department is sufficiently uniform, a cost per unit of output may be established. This departmental rate is applied to all jobs passing throught that department. d. Batch costing – A batch of similar products is regarded as one job, and the cost of this complete batch is collected. It si then used to determine the unit cost of the articles produced. This method is applicable to general engineering factories which produce components in convenient economical batches, biscuit and drug formulations. 2. Process Costing : This method of costing is used where it is impossible to trce the items of prime cost to a particular order because its identity is lost in volume of continues production. The following additional terms are used instead of process costing, but each is basically process costing : - a. Single, output or unit costing – This is used where a single article or services is produced. The whole production cycle is costed as a process or series of processes, and division by the total number of units produced yield the average final cost per unit. This method is applied to marble quarry, mining, steel works b. Operating or operative costing – This is applicable where services are rendered rather than goods produced. This procedure is same as in single costing. Operating costing applies to railway undertaking, road transport, telephone services, utilities etc. c. Operation costing – This is method of unit costing by operation connected with mass production and repetitive production having a number of distinct operations. 12

TECHIQUES OF COSTINGFollowing are the techniques used by cost planning and control :-1. Marginal Costing – It is the ascertainment, by differentiating between fixed costs and variable costs, of marginal costs and the effect on the profit of changes in volume or type of output. Here, variable costs are charged to products and fixed costs are charged to costing profit and loss account of the period in which they arise.2. Standard Costing – It is the ascertainment and use of standard cost and the measurement and analysis of variances between the standard costs and the actual costs incurred. Standard costing is frequently employed in conjunction with budgetary control. It permits management to investigate the reasons for variance and to take suitable corrective actions.3. Historical costing – It is the ascertainment of costs after they have been incurred. It has a limited utility although it permits comparision of costs over different periods.4. Direct costing - It is the practice of charging all direct costs to jobs, operations, processes, leaving all indirect costs to be charged to profit and loss account of the period in which they arise. Direct costing differ from marginal costing in that some fixed cost could be considered to be direct costs in appropriate circumstances and are charged to products, processes etc.5. Absorption costing – It is the practice of charging all costs, both variable and fixed to jobs operations or processes. It differes from marginal costing where only variable costs are charged to jobs, products etc and fixed costs are charged to profit and loss account.6. Uniform costing – It is the use by several undertaking of the same costing principles and /or practices. Thus they may adopt any one of the above mentioned types of costing. When used and operated under a central control, uniform costing promotes operating efficiency by ensuring inter unit and inter firm comparision. 13

LESSON 5COST:-An old adage in management Accounting recommends, “different costs for differentpurposes. This implies, that there is no single definition of cost. There are two reasons:-First, Costs are developed and used for some specific purpose, and, second, the way thecost is to be used will define the way it should be computed. Remember thus adage asyou study this chapter. In this chapter, we shall consider the identification and use ofcosts in making management decisions. We shall see that not all costs surrounding anarea are relevant to a particular decision. It is important to distinguish carefully betweencosts which are relevant and those which are not, sine failure to do so could well lead tobad decisions being made.Costs are the resources sacrificed or foregone to achieve a specific objective. Cost isdefined as the benefits given up to acquire goods or services. It is an exchange price, asacrifice made to secure some benefit. The benefits (goods or services) given up aremeasured in rupees by the reduction of assets or incurrence of liabilities. When benefitsare actually received, the cost becomes an expense. An expense is defined as a cost thathas given a benefit and has now expired. Unexpired costs that can give future benefits areclassified as assets. Anthony and Welsch say "Cost is a measurement in monetary termsof the amount of resources used for some purpose". The Chartered Institute ofManagement Accountants, London, defines cost as "The amount of expenditure (actual ornotional) incurred on or attributable to a specific thing or activity". Cost of a product hastwo components: quantity and price. These are the core costing pieces. Hence, C = Q ×P. If 10 gas cylinders are used for preparing snacks for a social gathering, and the price ofeach cylinder is Rs. 120, the total fuel cost of the function is said to be Rs. 1,200.A cost objective is any activity for which a separate measurement of costs is desired. Inother words, if the users of accounting information want to know the cost of something,this something is called a cost objective. Examples of cost objectives include the cost ofa product, the cost of rendering a service to a bank customer or hospital patient, the costof operating a department or sales territory or indeed anything for which one wants tomeasure the resources used.Cost ClassificationsProper cost classification is essential for management. Costs can be effectively collectedand used only after such a grouping. These can be classified according to their commoncharacteristics and in relation to some independent factor. The principal bases on whichcosts are classified are: 1. Variability (behavioural classification) 2. Functional areas (functional classification) 3. Responsibility (controllable and uncontrollable costs) 4. Traceability/identifiability (direct and indirect costs) 5. The accounting period charged to revenue (product costs and period costs) 6. Relevance to decision-making (relevant and irrelevant costs).Behavioural ClassificationThe basis of classification here is the behaviour pattern of costs. The consideration ishow the costs respond, i.e. change with a given change in the volume of production. 14

While some costs vary with the change in the quantity of output, others do not.Accordingly, there are three categories of costs: fixed, variable and semi-variable.Fixed costs. These are unaffected by variations in the volume of activity. The total fixedcosts remain constant over a relevant range of output, while the fixed cost per unit varieswith the output. Fixed costs have no particular relation to the volume of activity. Theseare incurred irrespective of production and sales. These are usually time-based. Sometypical examples are rent, insurance, taxes and supervisors salaries. Fixed costs- areagain divided into two categories. First, the committed fxed costs—costs which cannot bereduced as these are related to the long term policies -and planning of the Organisation.In general terms, these are sunk or irrecoverable costs in the given situation. Charges likedepreciation, rent, insurance, tax on property are committed to the period. Second, thediscretionary fixed costs-costs which may be reduced partially or dropped whollyaccording to the policy of the management and need of the situation. Expenses likeadvertisement, research, fees for consultancy and costs of training the top officials abroadduring the lean period of the business.Variable costs. These are the costs which vary in direct proportion to changes in volume.They increase or decrease in the same proportion in which the output increases ordecreases. The total amount of variable costs tends to change in respect to changes inproduction volume, but the variable cost per unit stays at the same level for aconsiderable period of time. The examples of such costs are direct material, directlabour, etc. When unit variable costs have an explicit relationship with physical volumeof production, the cost is termed as engineered to such volume. Hence, the termengineered cost. Assume that variable costs for direct materials are Rs. 100 per unit ofoutput. Each time output increases by one unit, variable costs will increase by Rs. 100.For 3000 units, the total variable costs for material will be Rs. 3,00,000, for 5000 unitsRs. 5,00,000, and for 1,900 units it will be Rs. 1,90,000.The behaviour of variable costs is illustrated below: 15

Semi-variable costs. Also known as mixed costs, these are neither wholly variable norwholly fixed in nature. They have the characteristics of both fixed and variable costs.The fixed part of semi-variable costs represents a minimum fees for making a particularitem or service available. The variable portion is the fee charged for actually using theservice each time. Examples of such costs are: telephone charges, repairs andmaintenance, electricity, depreciation, etc. For the purpose of planning and control, thesecosts must be separated into their fixed and variable elements. The main methods usedfor splitting such costs are: Scalter graph, high-low, simultaneous equation and leastsquares. Classification of costs according to behaviour is essential for 1. Effective cost control 2. Marginal costing and break-even analysis 3. Formulation of budget 4. Managerial decision-making.Functional ClassificationCosts classified according to managerial functions are accumulated according to theactivity performed. The costs of a typical organisation may be divided intomanufacturing, marketing, administrative and financing groups. These are discussedbelow:Manufacturing costs. These are related to the production of an item. These are the sumof direct materials, direct labour and factory overhead. In other words, these include allthe costs incurred in the factory up to that stage when the goods are ready for despatch.Examples are: salaries of factory manager, supervisors and foremen, rent, rates andinsurance of the factory, power and fuel used in the factory, depreciation, maintenanceand repairs of building, plant, machinery tools, etc.Administrative costs. These include all expenditures incurred in formulating the plans,directing the organisation and controlling the operations. A major portion of these costsare policy costs which are of fixed nature and, therefore, uncontrollable. These includesalaries paid to management and clerical staff, rent, rates and insurance of general offices,their lighting, heating and air-conditioning, depreciation of office buildings, furniture,machinery, etc.Selling and distribution costsSelling Costs. These are incurred to create and stimulate demand and to secure orders.These include salaries, commission and travelling expenses of salesmen and technicalrepresentatives and sales managers, advertising, catalogues, price lists, bad debts andcollection charges, cost of market research, etc.Distribution Costs. These are the costs incurred in moving the goods from the point ofproduction to the point of consumption. These include: warehouse expenses, carriageoutwards, depreciation and upkeep of delivery vans, wages of packers, van drivers, etc.Financing costs. These are costs incurred for raising and using capital, e.g. interest onloans and debentures, commission or brokerage on issue of shares and debentures,discount on the issue of shares and debentures, etc.Controllable and uncontrollable costs. Costs are also classified in terms of responsibilityover them. Responsibility carries the authority of the manager to influence costs-increaseor decrease their amount. As such, there are two groups: Controllable and uncontrollable. 16

Controllable Costs. Costs are said to be controllable when the amount of the costincurred can be influenced by the action of a specified member (manager or supervisor)of an undertaking.Uncontrollable Costs. Costs which cannot be influenced by the action of a specifiedmember (manager or supervisor) of an undertaking are known as uncontrollable costs.The distinction between controllable and uncontrollable costs depends upon a point ofreference. An item of cost may be uncontrollable at one level of management but thesame item may be controllable at another level of management. Almost all costs arecontrollable at some level of management. Segregation of costs into controllable anduncontrollable categories will help the management in fixing responsibilities of differentexecutives for unfavourable cost variances. An executive should be held responsible onlyfor those costs which are under his control.Product costs and period costs. Costs are also classified as to when they are chargedagainst revenue. The basis is the period benefitted by the particular cost. This is essentialin matching expenses against revenues in the relevant period. Such a grouping helpsmanagement in income measurement for the preparation of financial statements. Here,two categories are product costs and period costs.Product Costs. These are the costs directly identified with the product. These are the costof goods produced and kept ready for sale. They are direct materials, direct labour,variable factory overheads. These costs provide no benefit till the product is sold, and are,therefore, inventoried. When the products are sold, the total product costs are recorded asan expense, and is called cost of goods sold. It is matched against revenue for the periodin which products are sold.Period Costs. These are not directly related to the product and, therefore, not inventoried.If the period costs benefit only one accounting period, it is called a revenue expenditure.If they benefit two or more accounting periods, they are treated as assets till they arecharged as expenditure for the relevant years. Normally, expense of fixed nature likedepreciation of assets, insurance premium, rent and rates are treated as fixed costs. Thesecosts represent non-operating items and are related to passage of time and not to theproduction and sales of the period.In a manufacturing organisation all manufacturing costs are regarded as product costs andnon-manufacturing costs are regarded as period cost. In retailing and wholesalingorganisations goods are purchased for resale without changing their basic form. The costof goods purchased is regarded as product cost and all other costs such as administrationand selling and distribution are considered to be period costs.Direct and indirect costs. Costs are classified as direct and indirect costs on the basis oftheir identification with particular jobs, products or processes.Direct Cost. It is a cost which can be directly identified with a product, process ordepartment. Materials used and labour employed in manufacturing an article or in aparticular process of production, are common examples of direct costs.Indirect Costs. These costs are not traceable to any particular product, process ordepartment, but are common to different products, processes or departments. Factorymanagers salary, factory rent, depreciation of machinery, etc., are typical examples ofindirect costs. 17

The distinction between direct and indirect costs depends upon whether or not the costcan be identified with the activity or other relevant unit. A cost such as the plantsuperintendents salary can be readily identified with the plant and hence is a direct costof the plant. However, it is an indirect cost of any department within the plant or of anyline of product manufactured. This nature of business and cost unit chosen will determinewhich are direct and which are indirect costs.Direct costs are allocated whereas indirect costs are apportioned to different jobs,products or services on a reasonable basis. It may be noted that the more the share of thedirect costs in relation to the total cost of the product, the greater is exactness in costing.The reason for this is that indirect costs are apportioned on an arbitrary basis.Relevant and irrelevant costs. For managerial decision making, costs are sub-dividedunder: (i) Relevant costs; and (ii) Irrelevant costs.Relevant costs. These are costs which are relevant for decision-making (for the future)such as differential or incremental costs, opportunity costs, out-of-pocket costs, etc.These are discussed below:Differential Costs. Management is expected to make decisions and in doing so comparesalternatives. In making a decision, management compares the costs of the alternatives.The costs that remain the same in any case can be disregarded but the difference in costbetween alternatives is relevant to decision-making. A difference in cost between onecourse of action and another is differential cost. If a decision results in an increased cost,the differential cost may be called incremental cost. If the cost is decreased, thedifferential cost may be referred to as a decremental cost. A decision in favour of analternative is taken only when the incremental revenue between two levels of output isgreater than differential cost of those levels of activity. This differential cost is thedifference in net costs and benefits between two or more alternative courses of action. Ifthe selection of an alternative involves changes in variable costs only, marginal cost anddifferential costs are the same. However, a decision may involve changes in fixed costsalso.Opportunity Costs. In choosing between alternatives, management has to select the bestalternative but in doing so, has to give up the returns that could have been derived fromthe rejected alternatives. The sacrifice of a return or benefit from a rejected alternative isknown as the opportunity cost of the alternative accepted. Opportunity costs are notentered in the accounting records, yet they are used in decision-making. Oftenmanagement is confronted with alternatives, each having its advantages. For example,there may be an opportunity to make only one, of the two different products with thepresent facilities. It may be estimated that product A will contribute Rs. 56,000 a year toprofits and that product B will contribute Rs. 71,000 a year to profits. Product B shouldbe selected and the opportunity cost of selecting product B is the sacrifice of Rs. 56,000that could be earned by product A.Out-of-Pocket Costs. An out-of-pocket cost signifies the relevant cash expenditure whichis involved in a particular situation. Management decisions are directly affected by suchcosts. Thus, an out-of-pocket cost is the present or future cash expenditure connectedwith a certain decision which will change according to the nature of the decision made.For example, if it is proposed to replace the companys delivery trucks by an arrangementto deliver goods through public carriers, the depreciated value of the trucks is irrelevant 18

(being a sunk cost) to decide upon the proposal. But, the cost of fuel, drivers salary andmaintenance expenditure involved in using the truck should be relevant costs in decidingwhether the delivery system should be changed. These are out-of-pocket costs,Irrelevant costs. Are those which are not pertinent to a decision. These are the costs thatwill not be changed by a decision. Because irrelevant costs will not be affected, they maybe ignored in decision-making process. An example of irrelevant cost is that of sunk cost.Sunk Cost. It is a cost incurred as a result of decision made in the past which cannot bereversed or altered by any decision in the future. Sunk-costs are irrelevant for decision-making. The written down values of assets previously purchased are sunk costs. Let ussuppose the management of a company is considering the desirability of replacing anexisting machine by a new one. Suppose, an old machine originally costs Rs. 20,000 andit has been depreciated to the extent of Rs. 15000 so far. If it is scrapped (no value beingrealisable on sale) there will be an accounting loss of Rs. 5000. It would be wrong torecognise this loss as a cost for deciding upon the proposed replacement. The book valueof the existing machine is really a sunk cost and the decision to replace or not to replacethe machine will not make any difference to its undepreciated value. It is irrelevant to thequestion of replacing the existing machine. The difference in income which will resultfrom the installation of new machine and expected return on capital investment should bethe deciding factor. 19

Other Cost ConceptsShut down cost. These are the costs which will still be incurred although a plant is shutdown temporarily, e.g. rent, rates, depreciation, maintenance of plant, etc.Research cost. It is the cost of searching for new or improved products, new applicationof materials or new or improved methods of production.Development cost. It is the cost of the process which begins with the implementation ofthe decisions to produce a new/improved product. It ends with the commencement ofproduction of that product or method. Thus, it is the cost of commercial exploitation ofsuccessful research. Development cost of new products is treated as an item of deferredexpenditure to be spread over a number of years. It is charged to product costs whenproduction is fully established.Joint cost. These are the costs incurred up to the point in a given process whereindividual products can be identified. Whenever two or more products are produced outof the same basic raw material or process, the cost of material purchased and processingare called joint costs. Such costs have to be apportioned to various products on somebasis. Cost CentreIn an Organisation chart, the cost centre is at the lowest level. Also called expensecentre, the segment simply accumulates cost incurred. Its manager has no control oversales, revenue, profit and investment. His performance, therefore, is judged by comparingthe actual expenses against the budgeted expenses. The Chartered Institute ofManagement Accountants, London, defines the term cost centre as "a location, person oritem of equipment (or group of these) for which costs may be ascertained and used for thepurpose of control". Cost centres could be classified into • Personal cost centre; • Impersonal cost centre.Personal Cost Centre. A cost centre which consists of a person or group of persons.Impersonal Cost Centre. A cost centre which consists of a location or an item ofequipment (or group of these). Impersonal cost centres could be further divided into (i)operation cost centre and (ii) process cost centre. (a) Operation cost centre. A cost centre which consists of those machines and/or persons carrying out similar operations. (b) Process cost centre. A cost centre which consists of a specific or continuous sequence of operations.From the functional point of view, the cost centres may be of the following types: 1. Production cost center 2. Service cost center 3. Production-cum-service cost centre.Production Cost Centres. These include those departments that are directly engaged inmanufacturing activity and contribute to the content and form of finished product.Typical examples are: cutting, assembly and finishing departmentsService Cost Centres. These are cost centres which provide services or assistance to otherdepartments. These contribute to the production process in an indirect manner and do notshape the finished product. Examples are: personnel, cafeteria, maintenance department,steam plant, power plant, quality control department, etc. 20

Service-cum-production Cost Centres. Also known as mixed cost centres, these arebasically service cost centres but sometimes they may undertake some productive workalso. Typical example is tools department producing dies and jigs as well as servicingtools.Cost UnitThe extent to which the analysis of expenditure should be carried out will depend uponthe nature of business and degree of accuracy desired. Expenditure will ultimately becharged to cost units. A cost unit is defined as "a unit of quantity of product, service (ortime or a combination of these) in relation to which costs may be ascertained orexpressed". The cost unit must not be confused with the cost centre (although in somecases, they may be one and the same), which is usually an intermediate point to whichexpenditure can be charged for the later distribution, if necessary, between cost units.Thus cost unit is any convenient measure of activity giving a feel of what the enterprise isproducing. In case of bulk products, the unit of measurement is generally selected as thecost unit, e.g. a tonne of coal, a gallon of gasoline, a metre of cloth, a barrel of paint, abale of cotton, etc. The cost unit may correspond to each unit of product, e.g. anautomobile, a piano, a transistor-radio, a time piece, a typewriter. In other cases, theconvenient unit of costing is fixed according to the nature of the article, e.g. I 000 bricks,I 000 cigarettes, a gross of pencils. The cost units in the case of service undertakingsnaturally depend upon the nature of the service, e.g. a tonne-km/passenger-km intransportation, kilo-watt hour in electricity companies. A few examples of costunit/methods are given in Table 2. 1. TABLE : UNITS AND METHODS OF COSTING Industry Cost unit Costing method 1. Hospital/Nursing Per bed/out-patient visit Operating costing 2. Coal mining Per tonne Single costing 3. Interior decoration Each job Job costing 4. Pharmaceuticals 1 000 nos. tablets/capsules Process costing 5. Readymade garments Numbers Job costing 6. Aircraft Numbers Job costing 7. Automobile Numbers Process costing 8. Sugar Tonne/kilograms Process costing 9. Confectionery Per kg Process costing 10. Bicycle manufacturing Numbers Multiple costing 11.Iron and Steel Tonne Process costing 12. Textile Meter, yards Process costing 13. Transport Tonne-km/passenger-km Operating costing 14. Electricity Kilo-watt hour Operating costing 15. Gas Cubic meter Operating costing The cost units and centres should be those most natural to the business and which arereadily understood and accepted by all concerned. The selection of suitable cost centresand cost units depends upon a large number of factors such as 1. Organisation of a factory 2. Condition of incidence of cost 3. Availability of information 4. Requirements of costing 21

5. Managements of costing 6. Management policy regarding making a particular choice from several alternatives.COST ESTIMATION AND COST ASCERTAINMENT Cost estimation is the process of pre determining the costs of a certain product, job ororder. Such pre determination may be required for several purposes such as budgeting,measurement of performance efficiency, preparation of financial statement (valuation ofstock) make or buy decisions, fixation of the sale prices of the products etc. Costascertainment is the process of determining costs on the basis of actual data. Hencecomputation of historical cost is costs ascertainment while computation of future costs iscost estimation. Cost estimation as well cost ascertainment both are interrelated and are of immense useto the management. In case a concern has a sound costing system, the ascertained costswill greatly help the management in the process of estimation of rational accurate costswhich are so necessary for a variety of purposes stated above. Moreover the ascertainedcosts may be compared with the pre - determined costs on a continuing basis and properand timely steps e taken for controlling costs and maximizing profits. COST REDUCTION AND COST CONTROL Cost reduction and cost control are two different concepts. Cost control has achievingthe cost target as its objective while cost reduction is directed to explore the possibilitiesof improving the targets themselves. Thus cost control ends when targets are achievedwhile cost reduction has not visible end. It is continuous process. The difference betweentwo can be summarized as follow: 1. Cost control aims at maintaining the costs in accordance with established standards. While cost reduction is concerned with reducing costs. It is challenges all standards and endeavours to better them continuously. 2. Cost control seeks to attain lowest possible cost under existing conditions. While cost reduction recognizes no condition as permanent, since a change will result in lower cost. 3. In case of cost control, emphasis is on past and present, while in case of cost reduction it is on the present and future. 4. Cost control is preventive function, while cost reduction is a corrective function. It operates even when an efficient cost control system exists.Elements of Total CostIn every manufactured product or operation, there are three cost elements (or its integral).These are materials, labours and overhead. These primary elements provide managementwith information necessary for income measuring and product pricing. These are beingexplained as under:MaterialsMaterials indicate principal substances used in production. Examples are cotton, jute,iron-ore, silicon, etc. The cost of material is further divided into direct and indirectmaterials.Direct materials. These include all material directly used- in production and easilytraceable to a finished product. In other words, it is the material which can be measuredand charged directly to the cost of the product. Direct material includes the following: 22

1. All materials specially purchased for a particular job, order or process. 2. All materials including primary materials and raw materials purchased and subsequently issued from the stores for particular job, order, etc. 3. Components purchased or produced. 4. Materials passing from one operation or process to another-party finished goods. 5. Primary packing materials, e.g. cartons, wrappings, cardboard boxes, etc.Items such as import duties, dock charges, transport of materials, storing of materials,cost of purchasing and receiving materials and cost of rectifying materials are added tothe invoice price of materials and it is at this enhanced initial cost that the material ischarged.Indirect materials. These are materials which are used ancillary to manufacture andcannot be traced into the finished product. These form a part of manufacturing overhead.Examples are glue, thread, nails, consumable stores, printing and stationary material, etc.LabourLabour is the physical or mental effort expended on the production of an item. It is theactive factor of production as against material which is a passive factor. The cost oflabour is further divided into direct and indirect labour.Direct Labour. Direct labour cost consists of wages paid to workers directly engaged inmanufacturing or handling a product or engaged in a particular job or process. It can beassociated directly with the product. It is also known as process labour, productivelabour or operating labour.Indirect labour. This includes wages paid for all labour which is not directly engaged inchanging the shape or composition of raw materials. It cannot be traced directly to the,product. Like indirect material, indirect labour forms part of the manufacturingoverheads. Examples of indirect labour cost are wages paid to foremen, supervisors,store-keepers, time-keepers, salaries of office executives and the commission payable tosales representatives.The above direct and indirect classification is not strict enough. The classification of costbased on relationship to the product will change as the relationship changes. For example,iron and steel used in the manufacture of an automobile is direct material but that used incontainers for shipping them is an indirect material cost. So is the maintenance andsupervisory personnel in a manufacturing plant as their function is not directly related toproduction. But the maintenance personnel employed in a company that providesmaintenance services to others would be considered a direct costs.Direct ExpensesDirect expenses, also known as chargeable expenses, include any expenditure other thandirect material or direct labour directly incurred on a specific cost unit. Examples ofdirect expenses are as follows: 1. Hire of a special machinery or equipment for a particular order or product. 2. Cost of special layout, designs or drawings. 3. Maintenance cost of such equipment.Indirect ExpensesIndirect expenses are those incurred for the business as a whole rather than for aparticular order, job or product. Examples of such expenses are rent, lighting, insurancecharges, etc. 23

OverheadsOverheads may be defined as the aggregate of indirect material, indirect labour andindirect expenses. Thus, all indirect costs are overheads. These cannot be associateddirectly with specific products. Hence, the amount of overheads has to be allocated andapportioned to products and services on some reasonable basis. The synonymous term isburden. Overheads may be subdivided into the following groups: 1. Factory overheads. 2. Administrative overheads. 3. Selling and distribution overheads.Factory overheads. These include indirect material, indirect labour and indirect expensesincurred in the factory till that stage when goods are ready for despatch. Examples offactory overheads are as follows: 1. Indirect material such as consumable stores, cotton waste, grease and oil, small tools, etc. 2. Indirect wages such as salary of the factory manager, wages of the foremen, supervisors, time-keepers, storekeepers, etc. 3. Indirect expenses such as rent, rates and insurance, power & fuel, depreciation, repairs and maintenance of buildings, plant, machinery, tools, etc.Factory overheads are also known as works overheads, production overheads, etc.Administrative overheads. These consist of all the expenses incurred in connection withthe management functions of planning, directing and controlling the operations of anorganisation. The examples of administrative overheads are as follows: 1. Indirect material used in offices such as printing and stationery material. 2. Indirect labour such as salaries of clerks, secretaries and accountants, general manager, directors, executives, etc. 3. Indirect expenses such as office rent, lighting, heating and air-conditioning, depreciation, repairs and maintenance of office machines, legal charges, bank charges, audit fees, etc. Administrative overheads are also known as office on cost, establishment expenses, etc.Selling and distribution overheadsSelling Overheads. These are costs incurred to create and stimulate demand for theproduct, to secure orders etc. It includes catalogues and price lists, salaries andcommission of sales manager, travellers and agents, showroom expenses, advertising,cost of preparing tenders and estimates for special selling projects, after-sale service, etc.Distribution Overheads. Under this heading would be included warehouse expenses,carriage outwards, upkeep and running of delivery vehicles, packing cases, wages ofdespatch clerks and labourers, etc.Selling and distribution overheads are also known as marketing cost and are generallygrouped together because of the overlapping nature of the two function.Elements of cost: Elements of cost Direct Material Direct Labour Direct Expenses Overheads 24

Factory Overheads Office & Adm. Overheads Selling & Dist Overheads Indirect Material Indirect Labour Indirect ExpensesTotal Cost ComponentsThe computation of total cost of a product or service passes through several stages. Thesuccessive stages through which the costs flow give rise to major divisions of cost aregiven below: (i) Prime cost. Also called basic, first or flat cost, it consists of costs of direct material, direct labour and direct or chargeable expenses. (ii) Factory cost. Also known as works cost or manufacturing cost, it includes prime cost and the proportionate factory overheads. (iii) Office cost. Also called cost of production or gross cost, it is made up of factory cost plus office and administrative overheads. (iv) Total cost. Cost of production and selling and distribution overheads constitute the cost of sales or total cost. Components of Total CostDirect MaterialDirect Labour Prime cost or Direct cost or First costDirect expensesPrime cost plus Works or Factory cost or Production costoverheads or Manufacturing costWorks cost plusOffice and administration Office cost or Total cost of ProductionOverheadsOffice cost plusSelling and distribution Cost of sales or Total costOverheads 25

COST SHEETCost sheet is a document which provides for the assembly of the estimated cost in respectof the estimated detailed cost in respect of cost centers and cost units. It analyses andclassifies in a tabular form the expenses on different items for a particular period.Additional columns may also be provided to show the cost of a particular unit pertainingto each item of expenditure and the total per unit cost.Cost sheet may be prepared on the basis of actual data (historical cost sheet), on theestimated data (estimated cost sheet) depending on the technique employed and thepurpose to be achieved.The technique of preparing a cost sheet can be understood with the help of the followingillustration: COST SHEET Rs. Rs Opening stock of raw materials *** Add: Purchase of raw materials *** Less: Return to suppliers *** Less: Abnormal loss of materials *** Less: Closing stock of raw materials *** Raw materials consumed *** Direct wages *** Direct expenses *** Prime Cost *** Factory overhead expenses *** *** Add: Opening work-in-progress *** Less: Sale of scraps *** Less: *** Closing work-in-progress *** Factory Cost or Works Cost Office and administration overhead *** Cost of Production Add: Opening finished stock *** Less: Closing finished stock *** Cost of production of goods sold *** Selling overhead *** Distribution overhead *** Total cost or cost of sales *** Profit *** Selling price ***Items to be excluded from Cost SheetWhile preparing cost sheet, some broad categories of expenses are not to be included asthey are purely financial items, not forming part of cost of production. These are thefollowing: 27

(i) Purely Financial Charges 1. Loss on sale of investment, fixed assets, etc. 2. Fines and penalties 3. Interest on debentures, bank loans, fixed deposits, mortgages, etc. 4. Obsolescence loss, i.e. loss due to scrapping of a machinery before the expiry of its life 5. Damages payable through a court of law. (ii) Purely Financial Incomes 1. Interest received on bank deposits 2. Transfer fee received 3. Discount, commission received 4. Rent/Interest/Dividend receivable 5. Profit on sale of investments, fixed assets etc. 6. Damages received through a court of law. (iii) Appropriation of Profits 1. Writing-off goodwill, preliminary expenses, capital raising expenses, discount on the issue, of shares and debentures 2. Income tax 3. Dividend on shares 4. Charitable donations 5. Appropriation to sinking fund 6. Transfer to reserves 7. Excess provision for depreciation due to change in method of charging depreciation etc. (iv) Abnormal Gains and Losses 1. Abnormal losses of materials 2. Abnormal idle time of labour.Now let us see some examples regarding preparation of cost sheet. 28

Illustration The following information has been obtained from the records of left center corporationfor the period from Jan 1st to Jan 30th 2003 : Cost of raw material on June 1st ’03 Rs 30,000 Purchase of raw materials during the month 4,50,000 Wages Paid 2,30,000 Factory Overhead 92,000 Cost of work in progress on June 1st’03 12,000 Cost of raw materials on June 30th ’03 15,000 Cost of stock of finished goods on June 1st ’03 60,000 Cost of stock of finished goods on June 30th ’03 55,000 Selling and distribution overheads 20,000 Sales 9,00,000 Administration overheads 30,000Prepare statement of costSolution:STATEMENT OF COST OF PRODUCTION OF GOODS MANUFACTUREDFor the period ending on June 30th ‘03Opening Stock of raw material Rs. 30,000Add: Purchase 4,50,000 4,80,000Less: Clsoing stock of raw materials 15,000Value of raw materials consumed 4,65,000Wages paid 2,30,000PRIME COST 6,95,000Factory overhead 92,000 7,87,000Add: Opening stock of work in progress 12,000 7,99,000Less: Closing stock of work in progress ----FACTORY COST 7,99,000Administration overhead 30,000Cost of production of goods manufactured 8,29,000Add: Opening stock of finished goods 60,000 8,89,000Less: Closing stock of finished goods 55,000COST OF PRODUCTION OF GOODS SOLD 8,34,000Selling and distribution overheads 20,000COST OF SALES 8,54,000PROFIT 46,000SALES 9,00,000Let us solve some more questions on cost sheet.ILLUSTRATION 1. The cost accounts of a manufacturing business reveal the followinginformation for April, 1996: 29

Rs. Material at the beginning 7,000 Indirect wages. 1,000 Wages 8,000 Purchases during the year 10,000 Defective material (scrap) 100 Overtime 200 Stores 400 Loose tools 100 Advertisement 600 Trade discount 100 Raw material at the end 3,000 Carriage inward 400 Depreciation 300 Insurance 100 Bank interest 600 Dividend 1,000 Provision of sinking fund 1,500 Inspection fee 100 Postage 200 Technical directors fee 1,500 Managers salary (factory) 2,000 Supervision expenses 100 Research expenses 1,200 Cleaning charges 100 Subscription for trade journal 10 Collection charges 20Prepare a statement so as to show: (a) prime cost (b) works cost (c) cost of production (d) % of works oncost to prime cost (e) % of general oncost to works cost. 30

SOLUTION COST SHEET (for April, 1996) Particulars Rs. Amount (Rs.) Opening stock of raw material 7,000 Add: Purchases 10,000 Carriage inward 400 17,400 Less: Closing stock of raw material 3,000 14,400 Less: Scrap 100 Cost of Material 14,300 Direct wages 8,000 Prime Cost 22,300 Add. Factory expenses: Indirect wages 1,000 Overtime 200 Stores 400 Loose tools 100 Depreciation 300 Insurance 100 Inspection fee 200 Technical directors fee 1,500 Managers salary 2,000 Supervision 100 Research expenses 1,200 Cleaning charges 100 7,200 Works Cost 29,500 Add. Office and administrative expenses: Postage 200 Advertisement 600 Collection charges 20 Subscription for trade journal 10 Discount 100 930 Total cost 30,430 31

Illustration 2.ABC Ltd., a manufacturing company, incurred the following expenses during a certainperiod. You are required to prepare a statement showing the sub-division of total cost. Rs. Rs.Materials used on jobs 1,20,540 Depreciation of plant 3,800Wages traceable to jobs 86,650 Depreciation of delivery vans 1,600Wages paid to men on Insurance on finished goods 2,500maintenance work 12,600 Lubricating oil 250Salesmens salaries 15,100 Bad debts 300Directors fees 10,000 Commission to salesmen 2,850Carriage inwards on raw materials 860 Cost of idle time in factory 510Carriage outwards 2,800 Auditors fees 3,800Factory rent and rates 8,300 Dividends paid 6,800Works salaries 20,400 Lighting of showroom 1,500Hire of crane for job No. 132 1,300 Office salaries and expenses 7,000Consumable stores 340 Income tax 8,600Solution Statement of Cost Period................. Rs. Rs.Direct materials 1,20,540Add: Carriage inwards 860 1,21,400Direct wages 86,650Direct expenses (hire of crane for Job No. 132) 1,300Prime cost 2,09,350Works overhead Wages paid to men on maintenance work 12,600 Factory rent and rates 8,300 Works salaries 20,400 Consumable stores 340 Depreciation of plant 3,800 Lubricating oil 250 1 Cost of idle time in factory 510 46,200Works cost 2,55,550Administration overhead Directors fees 10,000 Auditors fees 3,800 Office salaries and expenses 7,000 20,800Cost of production 2,76,350Selling and distribution overhead Salesmens salaries 15,100 Carriage outwards 2,800 Depreciation of delivery vans 1,600 Insurance of finished goods 2,500 Commission to salesmen 2,850 Lighting of showroom 1,500 Bad debts2 300 26,650Total cost 3,03,000 32

Notes: 1. Assumed that the idle time and bad debt are within normal limits. 2. Dividend paid Rs. 6,800 and Income tax Rs. 8,600 have not been included in the Statement of Cost, because these are appropriation of profits and not expenses of the business.Illustration 3.The accounts of P. K. Manufacturers Ltd. for the year ending on 31st December, 1995,show the following: Rs. Stock of materials on 1st January, 1995 67,200 Materials purchased 2,59,000 Bad debts written off 9,100 Travellers salaries and commission 10,780 Depreciation written off on office furniture 420 Rent, rates, taxes and insurance (factory) 11,900 Productive wages 1,76,400 Directors fees 8,400 General expenses 4,760 Gas and water (factory) 1,680 Travelling expenses 2,940 Sales 6,00,000 Managers salary (2/3rds for factory, 1/3rd for office) 15,000 Depreciation on plant and machinery 18,200 Cash discounts allowed 4,060 Repairs to plant and machinery 6,230 Carriage and cartage outwards 6,020 Direct expenses 10,010 Rent, rates and insurance (office) 2,800 Gas and water (office) 560 Stock of materials as on 31st December, 1995 87,920Prepare a statement giving the following information : (i) Materials consumed; (ii) Primecost; (iii) Factory cost; (iv) Cost of production; (v) Cost of sales; (vi) Net profit. 33

Solution Statement of Cost Period: year ended 31.12.95 Rs. Rs.Materials consumed : Opening stock … 67,200 Purchases … 2,59,000 3,26,200 Less : Closing stock … (87,920) 2,38,280 Productive wages … 1,76,400 Direct expenses … 10,010 Prime cost … 4,24,690Factory expenses : Rent, rates, taxes and insurance … 11,900 Gas and water … 1,680 Managers salary (2/ 3 × 15,000) … 10,000 Depreciation on plant and machinery … 18,200 Repairs to plant and machinery … 6,230 48,010 Factory cost … 4,72,700Office and administration expenses: Directors fees … 8,400 General expenses … 4,760 Managers salary (1/ 3 × 15,000) … 5,000 Rent, rates and insurance … 2,800 Gas and water … 560 Depreciation on furniture 420 21,940Cost of production … 4,94,640Selling and distribution expenses Travelers salaries and commission … 10,780 Traveling expenses … 2,940 Bad debts … 9,100Carriage and cartage outwards … 6,020 28,840Cost of sales … 5,23,480Net profit (balancing figure) … 76,520Sales … 6,00,000 34

Notes: 1.It has been assumed that travelling expenses have been incurred in connection with sales. 2. Cash discount has been treated as a financial charge and excluded from Cost Accounts.Illustration 4.The following figures are extracted from the books of a manufacturing company for theyear ended 3lst Marc4, 1995. Prepare a cost sheet showing clearly the cost per unit underthe various elements and also the profit/ loss per unit. Rs. Rs. Direct materials 25,00,000 Branch office expenses 30,000 Direct labour 8,00,000 Depreciation of office building 10,000 Depreciation of factory 16,000 Depreciation of staff cars 15,000 building Insurance : Electricity (including Rs. 5000 35,000 for administrative office Staff cars 2,000 Office building 1,500 Advertisement 18,000 Factory building 2,000 Sundry factory expenses 4,20,000 Delivery van-maintenance 12,000 Sales promotion 4,000 and running expenses Office administration expenses 60,000 Salaries (including that of 2,75,000 Expenses for participating in 8,000 Sales Manager Rs. 20,000 industrial exhibition and, Factory Chief Engineer Rs. 25,000) Finished goods warehouse 15,000 Sales (10,000 units) 50,00,00 expenses 0 Units produced—10,000 35

Solution : Cost SheetOutput: 10,000 units Period: year ended 31.3.95 Total Per unit Rs. Rs. Rs. Rs.Direct materials … 25,00,000 250.00Direct labour … 8,00,000 80.00 ———— ———— Prime cost 33,00,000 330.00Works overhead:Depreciation of factory building … 16,000 1.60Insurance of factory building … 2,000 0.20Salary of factory chief engineer … 25,000 2.50Electricity (35,000 - 5,000) … 30,000 3.00Sundry factory expenses … 4,20,000 42-00 ———— ———— 4,93,000 49-30 ———— ————Works cost … 37,93,000 379,30Office and administration overhead: Depreciation of office building … 10,000 1.00 Depreciation of staff cars … 15,000 1.50 Insurance of staff cars … 2,000 0.20 Insurance of office building … 1,500 0.15 Salaries (2,75,000 - 20,000 - 25,000) … 2,30,000 23.00 Electricity … 5,000 0.50 Other office administration expenses … 60,000 6.00 ———— ———— 3,23,500 32-35 ———— ———— Cost of production 1,16,500 411.65Selling and distribution overhead Sales managers salary … 20,000 2-00 Advertisement … 18,000 1.80 Sales promotion … 4,000 0.40 Expenses in industrial exhibition … 8,000 0.80 Branch office expenses … 30,000 3.00 Finished goods warehouse expenses … 15,000 1.50 Delivery van-maintenance and running expenses … 12,000 1.20 ———— ———— l,07,0,00, 10.70 ———— ———— Cost of sales … 42,23,500 422-35 Profit (balancing figure) 7,76,500 77-65 ———— ———— Sales 50,00,000 500-00 36

Illustration 5.From the following figures prepare separate statements of cost and profit for the onth ofOctober, 1995 : Rs. Rs.Stock on 1st October, 95 Purchase of raw materials 2,85,100 Raw materials 60,600 Sale of finished goods 13,40,000 Finished goods 35,900 Direct wages 3,75,000Stock on 31st October, 95 Factory expenses 2,12,500 Raw materials 75,000 Office and administration Finished goods 30,900 expenses 1,03,400Work-in-progress : Selling and distribution On 1st October, 95 1,25,600 expenses 75,000 On 31st October, 95 1,42,200 Sale of scrap 2,600 37

Solution: Statement of Cost of Production Period: October, 1995 Rs. Rs.Materials consumed: Opening stock … 60,600 Purchases … 2,85,700 ———— 3,46,300 Less : Closing stock … (75,000) 2,71,300Direct wages … 3,75,000 ———— Prime cost 6,46,300 Factory expenses … 2,12,500 Less : Sale of scrap … (2,600) 2,09,900 ———— ———— … 8,56,200Adjustment for work-in-progress Opening … 1,25,600 Closing … (1,42,200) (16,600) ———— ———— Works cost … 8,39,600 Office and administration expenses … 1,03,400 ———— Cost of production … 9,43,000 Statement of Profit or Loss Period: October, 1995 … Rs.Stock of finished goods on 1st October, 95 … 35,900Add: Cost of production … 9,43,000 ———— … 9,78,900Less: Stock of finished goods on 3lstOctober,95 … (30,900) ———— Cost of goods sold … 9,48,000Selling and distribution expenses … 75,000 ———— Cost of sales … 10,23,000Profit (balancing figure) … 3,17,000 ————Sales 13,40,000 Note: Office and administration expenses may also be shown in the Statement of Profit or Loss . 38

Illustration 6.The SUSAN Company makes art prints. The following details are available for the yearended 30th June, 1995 : Rs. (thousands) Rs. (thousands)Opening stocks: Direct materials 26 Selling expenses 140 Work-in-progress 74 Factory powcr, heat and light 20 Finished goods 120 Sundry factory overheads 12 Direct materials purchased 436 Financial charges 120 Direct labour 120 Sales 1,460 Indirect labour and supervision 44 Closing stocks Administrative expenses 160 Direct materials 42 Factory rent, rates and insurance 94 Work-in-progress 54 Depreciation of factory equipment 70 Finished goods 80The company values work-in-progress at factory cost.You are required to prepare : (a) A schedule of cost of goods manufactured for the year ended 30th June, 1995. (b) A profit statement for the year ended 30th June, 1995. 39

Solution Schedule of Cost of Goods Manufactured Pending 4 year ended 30th June, 1995 Rs. Rs. (thousands) (thousands)Direct materials consumed: Opening stock … 26 Purchases … 436 ——— ... 462 Less: Closing stock … (42) ——— 420 Direct labour … 120 ——— Prime cost … 540Factory Overhead : Indirect labour and supervision … 44 Rent, rates and insurance … 94 Depreciation of equipment … 70 Power, heat and light … 20 Sundry … 12 ——— 240 ——— 780Adjustment for work-in-progress: … Opening … 74 Closing … (54) ——— 20 ———Cost of goods manufactured … 800 40

Profit Statement Period: year ended 30th June, 1995 Rs. P, S. (thousands) (thousands)Sales 1,460Less Cost of goods sold: Opening stock of finished goods … 120 Cost of goods manufactured … 800 ——— 920 Less : Closing stock of finished goods … (80) ——— (840) ——— Gross profit… 620Less: Administrative expenses … 160 Selling expenses … 140 Financial charges … 120 (420) ———Net profit … 200 41

Illustration 7.A company is manufacturing refrigerators and the following details are furnished inrespect of its factory operations for the year ended 3 1 st December, 1995 :Work-in-progress 1st January, 1995 Rs. Rs. At prime cost 51,000 Manufacturing expenses 15,000 ——— 66,000Work-in-progress, 31st December, 1995 At prime cost 45,000 Manufacturing expenses 9,000 ——— 54,000 Stock of raw materials, 1st January, 1995 2,25,000 Purchase of raw materials 4,77,000 Direct labour 1,71,000 Manufacturing expenses 84,000 Stock of raw materials on 31st December, 1995 2,04,000On the basis of above data, prepare a statement showing the cost of production.Solution: Schedule of Cost of Production Period: year ended 31st Dec., 95 Rs. Rs.Raw materials consumed: Opening stock … 2,25,000 Purchases … 4,77,000 ———— 7,02,000 Less: Closing stock … (2,04,000) ———— 4,98,000 Direct labour … 1,71,000 ———— 6,69,000Adjustment for work-in-progress Opening … 51,000 Closing … (45,000) ———— 6,000 ———— Prime cost … 6,75,000 Manufacturing expenses … 84,000 Adjustment for work-in-progress Opening 15,000 Closing (9,000) ———— 6,000 ———— 90,000 ———— 42

Cost of production 7,65,000Illustration 8. The accounts of the Steelways Engineering Co. Ltd. show for 1995 : Rs. Materials used 1,80,000 Manual and machine labour wages directly chargeable 1,60,000 Works overhead expenditure 40,000 Establishment and general expenses 19,000 (a) Show the works cost and total cost, the percentage that the works overhead cost bears to the manual and machine labour wages and the percentage that the establishment and general expenses bear to the works cost. (b) What price should the company quote to manufacture a machine which, it is estimated will require an expenditure of Rs. 8,000 on materials and Rs. 6,000 on wages so that it will yield a profit of 25% on the total cost or 20% on selling price.Solution: Statement of Cost Period: year ended 31st December, 95 Rs.Materials used … 1,80,000Manual and machine labour wages (directly chargeable) … 1,60,000 ———— Prime cost … 3,40,000Works overhead expenditure … 40,000 ———— Works cost … 3180,000Establishment and general expenses … 19,000 ———— Total cost … 3,99,000 ————Percentage of works overhead to manual and machine labour 40,000 ——— x 100 … 25% 1,60,000Percentage of establishment and general expenses to works cost 19,000 ——— x 100 … 25% 3,80,000 43

Statement of Estimated Cost for the Manufacture of the MachineEnquiry from …………………… … Rs. Cost of materials … 8,000 Direct wages … 6,000 ———— Prime cost … 14,000 Works overhead : 25% of wages … 1,500 ———— Works cost … 15,500 Establishment and general expenses: 5% of works cost … 775 ———— Total cost … 16,275 Profit (20% on selling price or 25% on cost) … 4,069 ———— Price to be quoted … 20,344Illustration 9.From the following particulars prepare a statement in such form as you consider mostsuitable for showing clearly all elements of cost: Rs. Rs. Opening stock of raw materials 25,000 Carriage on goods sold 1,500 Purchase-of raw materials 70,000 Rent and rates of workshop 2,500 Raw materials returned to suppliers 2,000 Fuel, gas, water etc. 1,000 Closing stock of raw materials 181,800 Repairs to plant 600 Wages paid to- , Depreciation on machinery 1,400 Productive workers 18,000 Office expenses 1,500 Non-productive workers 2,000 Direct chargeable expenses 800 Salaries paid to office staff 5,000 Advertising 1,200Carriage on raw materials purchased 500 Abnormal loss of raw materials 1,200 44

Solution : Statement of Cost Period…………… Rs .Rs. Materials consumed: Opening stock … 5,000 Purchases … 70,000 Carriage on purchases … 500 ——— 95,500 Less : Returns … (2,000) ——— 93,500 Less: Abnormal loss1 … (1,200) ——— 92,300 Less : Closing stock (18,800) ——— 73,500 Productive wages 18,000 Direct chargeable expenses … 800 ——— Prime cost … 92,300 Works overhead: Non-productive wages … 2,000 Rent and rates of workshop … 2,500 Fuel, gas, water etc. … 1,000 Repairs to plant … 600 Depreciation on machinery … 1,400 ——— 7,500 ——— Works cost 99,800 Office overhead: Salaries to office staff … 5,000 Office expenses … 1,500 ——— 6,500 ——— Cost of production … 1,06,300 Selling and distribution overhead: Caniage on goods sold … 1,500 Advertising … 1,200 ——— … 2,700 ——— Cost of sales … 1,09,000Note: 1Abnormal loss of materials should be excluded from cost and debited to Costing Profit & Loss A/c, hence it has been deducted from materials cost. 45

Illustration 10.The following data relate to the manufacture of a standard product during the four week-period to June 30th, 1995 : Raw materials consumed Rs. 4,000 Wages Rs. 6,000 Machine hours worked 1,000 Machine hour rate 50 paise Office overhead 20% on works cost Selling overhead 6 paise per unit Units produced 20,000 Units sold 18,000 @ Re. 1 per unitYou are required to prepare a cost sheet showing the cost per unit and profit for theperiod.Solution: Cost SheetOutput: 20, 000 units Period: 4 weeks ended 30.6.95 Total Per unit Rs. Rs. Raw materials consumed … 4,000 0.200 Wages … 6,000 0.300 ——— ——— Prime cost … 10,000 0.025 Works overhead (1,000 hrs. @ Rs. 0.50) … 500 0.025 ——— ——— Works cost … 10,500 0.525 Office overhead (20% on works cost) … 2,100 0.105 ——— ——— Cost of production … 12,600 0.630 Less: Closing stock (2,000 units @ Re. 0-630) … (1,260) — ——— ——— Cost of goods sold (1 8,000 units) 11,340 0.630 Selling overhead (Re. 0.06 per unit on 18,000 units) … 1,080 0.060 ——— ——— ——— ——— Cost of sales … 12,420 0.690 Profit (balancing figure) … 5,580 0.310 ——— ——— Sales … 18,000 1.000 46

TERMS USED IN COST ACCOUNTINGThe following are some of the terms used frequently in cost accounting and managerialdecision making :- i. Added value - It is the increase in market value of a product less bought out materials and services. It includes profit unlike conversion cost. ii. Avoidable costs – Avoidable costs are those costs which under given conditions of performance efficiency should not have been incurred e.g. cost of abnormal spoilage (in excess of normal limit). Such costs are relevant for purposes of decision making. iii. Contributions (margin) – This is the excess of sales price over variable cost and is also called marginal income. It may be expressed in total, ratio or percentage to sales. iv. Cost of carrying – These are unavoidable costs of carrying inventory and include interest on investment, obsolescence, write offs rent of stores and other space costs. Overstocking increases costs of carrying. v. Cost of non carrying – These include expensive expediting, loss of sales and loss of goodwill on account of failure to maintain delivery schedule. These are more difficult to measure and are potentially harmful. vi. Discretionary costs – These are also called managed costs or programmed costs and consist of fixed costs that arise from periodic appropriation decision that directly reflect top management policies. vii. Engineered costs – These are costs which vary directly with the level of production. These are opposed to managed or discretionary costs. viii. Joint product cost – Costs of two or more manufactured goods, of significant sales values, that are produced by a single process and are not identifiable to individual products up to a certain stage of production known as the split off point. ix. Linear Programming – A mathematical approach to a group of problems which contain interacting variable and which involve combining limited resources to profit maximization or cost minimization. x. Management by exception – It is the practice of focusing the attention of management mainly on significant deviations from expected results. It is also called management by variance. xi. Operations research (OR) – It is the diffused collection of mathiematical and statistical model applied to managerial decision making. xii. PERT or Programme evaluation and review technique – It is a formal probabilitistic diagram of the temporal inter relationships of a comlex series of activities. xiii. Responsibilities Accounting – A system of accounting which establishes various responsibility centers in an organization and which reflects the plans 47

and actions of each of these centers by allocating particular revenues and costs etc. to the one having the pertinent responsibility. It fixes responsibility for cost control purposes. xiv. Shut down cost – A cost which will still be incurred although a plant is shut down temporarily, e.g. rent rates depreciation maintenance of plant etc xv. Unavoidable costs – These are inescapable cost incurred. Thus salary of works manager or factory rent cannot be avoided even if volume or production is reduced to a certain extent.Review questions : 1. Tabulate the "Elements of Cost" showing the usual items of expenditure under each. 2. Illustrate by means of a chart the components which make up the selling price of a product. 3. Explain the terms (i) direct expenditure and (ii) indirect expenditure and state the elements of cost comprised in each. 4. Explain the following and give examples: (a) Direct material and Indirect material (b) Direct wages and Indirect wages. 5. (a) Explain the meaning of the terms direct costs and indirect costs (overheads) in relation to the manufacture of goods. (b) Classify the following lists of costs, as either a prime cost or a factory overhead : (i) Raw materials purchased (ii) Factory rent and rates (iii) Plant depreciation (iv) Wages of factory cleaners (v) Raw materials sold as scrap (vi) Carriage inwards. 6. (a) Explain briefly the difference between a direct cost and an indirect cost, giving an example of each type. (b) For each of the following items, state whether they are direct or indirect costs : (i) Sheet steel for a motor car manufacturer. (ii) Machine operators wages for a golf-ball manufacturer. (iii) Supervisors wages for a golf-ball manufacturer. (iv) Chargeable time in an accountancy practice. (v) Factory rates for an oven manufacturer. (vi) Production royalties for a mining company. (vii) Electricity for a brewery. (viii) Hire of plant for a building contractor in a long-term contract. (ix) The audit fee of an oil company. (x) Adhesive for a furniture maker. 48

7. What do you mean by chargeable expenses ? Give three examples. 8. Classify costs according to element, function and variability and give two examples of each. 9. You are required to state why it is important to distinguish between "fixed" and 11 variable" expenses in Cost Accounting, and give two examples of each type of expenses. 10. Define fixed expenses, variable expenses and semi-variable expenses, giving three examples of each. 11. Explain fixed, variable and semi-variable overhead. Give one example of each overhead to illustrate your answer. 12. (a) Define: (i) prime cost; (ii) factory overhead. (b) Give three examples of each of the following: (i) Fixed factory overhead (ii) Variable factory overhead (iii) Partly-variable factory overhead. 13. Explain the distinction between direct and indirect expenditure giving suitable illustrations. When the Works Cost has been determined, what are the further elements to be added thereto to determine the Cost of Sales 14. Distinguish clearly between direct and indirect materials. Under what circumstances may direct materials be charged indirectly to the finished product. 15. Distinguish between (a) Cost of sales and cost of goods sold. (b) Direct expenditure and indirect expenditure. (c) Fixed cost and Variable cost. 16. Suggest six different bases under which cost may be classified, and for each basis, suggest the different classifications of costs contained therein. 17. What do you mean by overhead expenditure? Give the functional classification of overhead expenditure with two examples of each class. 18. What are the differences between Selling and Distributing expenses? Give five examples of each category. 19. Distinguish between Direct labour and Indirect labour. 20. List any ten items of factory overhead. 21. Distinguish between chargeable expenses and overhead expenses. 22. Do you agree with the following statement? Justify your answer in brief. Fixed cost per unit remains constant with the increase in production . Practical Problems for practice :-1.The following figures for the month of April, 1995 were extracted from the records of afactory: Rs. Opening stock of finished goods (5,000 units) 45,000 Purchase of raw materials 2,57,100 Direct wages 1,05,000 Factory overhead 100% of Direct wages 49

Administration overhead Re. I per unit Selling and distribution overhead 10% of sales Closing stock of finished goods (10,000 units) ? Sales (45,000 units) Rs. 6,60,000 Prepare a cost sheet for the month of April, 1995, assuming that sales are made on thebasis of first-in-first-out principle.2. From the following particulars relating to the production and sales for the year ended 31 st December, 1992, prepare a cost statement showing therein (i) the Prime Cost, (ii) theWorks Cost, (iii) the Cost of Production, (iv) the Cost of Sales and (v) the Profit or Loss. Stock as on 1. 1.92 : Rs. (a) Raw materials- 25,000 (b) Work-in-progress- At Prime Cost Rs. 30,000 Add Manufacturing expenses Rs. 6,000 36,000 (c) Finished goods (at cost) 1,44,000Raw materials purchased 2,00,000Freight on raw materials 10,000Machine hour rate 3Machine hours worked: 48,000 hoursChargeable expenses 50,000Factory wages for direct labour 2,70,000Administration expenses 1,00,000Selling expenses 54,000Distribution expenses 36,000Sale proceeds of finished goods (30,000 units) 9,00,000Stock as on 31st December, 1992 : (a) Raw materials 45,000 (b) Work-in-progress At Prime Cost Rs. 45,000 Add Manufacturing expenses Rs. 9,000 54,000 (c) Finished goods at cost (10,000 units) ? finished goods produced 32,000 units Apply LIFO principle in finished goods valuation.3.A manufacturing company submits the following information on 3 1 st March, 1995 Rs. Sales for the year 2,75,000 Inyentories at the beginning of the year: Rs. Materials 3,000 Finished goods 7,000 Work-in-progress 4,000 Purchases of raw materials for the year 1,10,000 Direct labour 65,000 Inventories at the end of the year Materials 4,000 Work-in-progress 6,000 Finished goods 8,000 50

Other expenses for the year: Selling expenses @ 10% of sales Factory overhead @ 60% of direct labour cost Administrative expenses @ 5% of sales Prepare a statement of cost.4.The books of a manufacturing company present the following data for the month ofApril, 1992:Direct labour cost Rs. 17,500 being 175% of works overhead. Cost of goods soldexcluding administrative expenses Rs. 56,000.Inventory accounts showed the following opening and closing balances April 1 April 30 Rs. Rs. Raw materials 8,000 10,600 Work-in-progress 10,500 14,500 Finished goods 17,600 19,000 Other data are : Rs. Selling expenses 3,500 General and administration expenses 2,500 Sales for the month 75,0005.Sreelekha Mfg. Co. manufactures two types of pens P and Q. The cost data for the yearended 30th June, 1995 is as follows Rs. Direct materials 4,00,000 Direct wages 2,24,000 Production overhead 96,000 7,20,000It is further ascertained that (a) Direct materials in type P cost twice as much direct materials as in type Q. (b) Direct wages for type Q were 60% of those for type P. (c) Production overhead was of the same rate for both types. (d) Administration overhead for each was 200% of direct labour. (e) Selling costs were 50 paise per pen for both types. (t) Production during the year Type P 40,000 Type Q 1,20,000 (g) Sales during the year Type P 36,000 Type Q 1,00,000 (h) Selling prices were Rs. 14 per pen for type P and Rs. 10 per pen for type Q. Prepare a statement showing per unit cost of production, total cost, profit and also totalsales value and profit separately for the two types of pen P and Q. (ICWA Inter.)6.A critical study of past expenses incurred on the manufacture of two kinds of acidcontainers (drums) shows:Nature of Expense Expenses incurred on the manufacture of acid containers Type "X" Type "Y" 51

Rs. Rs. Direct materials 3.50 6-50 Direct wages 1.00 1.50 Plant and machine usage allocated on hourly basis 2.00 3.00 General overhead apportioned at 200% of direct wages 2.00 3.00 Cost per container 8.50 14.00 Cost record for the month of August, 1995 shows Rs. Direct materials utilised 26,500 Direct wages 5,850 Plant and machine usage 16,250 General overheads 11,700 ——— Total 60,300 ———Containers produced : Type X 2,000 units and Type Y 3,000 units. Prepare a consolidated cost sheet distributing the total production cost between the twotypes of containers according to the different elements of cost and also showing cost percontainer of each type.7.A factory produces and sells 1,000 units of a product in July, 1995, for which thefollowing particulars are available :Stock of direct materials on 1.7.95 … Rs 6,000Purchase and receipt of direct materials in July, 1995 … Rs. 1,44,000Direct wages paid in cash in July, 1995 … Rs. 55,000(which includes Rs. 3,000 on account ofJune, 1995 and an advance of Rs. 2,000)Works overhead charges for the month … Rs. 60,000Stock of direct materials on 31.7.95 … Rs. 10,000Administration and selling overheads … Rs. 25 per unitSales price … Rs. 300 per unitFrom the above particulars you are required to (a) prepare a cost statement for July,1995, (b) estimate the sale price of a unit of the same product in August, 1995, assuming- (i) 20% increase in direct materials cost, (ii) 10% increase in direct wages, (iii) 5% increase in works overhead charges, (iv) 20% reduction in administration and selling overhead charges, and (v) Same percentage of profit on sales price as in July, 95.8.The following particulars are available for the previous your’s production of fans forM/s. Eastern Engineering Co.: (i) Total productin-1,000 units. (ii) Total cost of raw materials consumed—Rs. 12,000. (iii) Total cost of direct labour-Rs. 20,000. (iv) Total works overhead expenses-Rs. 40,000. (v) Total general overhead expenses-Rs. 36,000. (vi) Total selling and distribution overhead expenses-Rs. 16,000. (vii) Total sale price for 800 units sold-Rs. 1, 12,640. 52

On the basis of the undemoted instructions prepare a detailed price quotation per unit offan for the current year: (a) Cost of raw materials and direct labour are to increase by 10% and 15% respectively over the previous years level. (b) Works overhead, general overhead, as well as selling and distribution overhead are to be charged at the same respective percentages as in the previous year. (c) Profit is to be estimated at the same percentage on Total Cost as is earned in the previous year.9.Bharat Electronics Ltd. furnishes the following information for 10,000 TV valvesmanufactured during the year, 1995 : Rs. Rs.Materials 90,000 Clerical salaries andDirect wages 60,000 management expenses 33,500Power and consumable stores 12,000 Selling expenses 5,500Factory indirect wages 15,000 Sale proceeds of scraps 2,000Lighting of factory 5,500 Plant repairs &Defective work maintenance and depreciation 11,500 (cost of rectification) 3,000The net selling price was Rs. 31-60 per unit sold and all the units were sold.As from I st January, 1996, the selling price was reduced to Rs. 31 .00 per unit. It wasestimated that production could be increased in 1996 by 50% utilizing spare capacity.Rates for materials and direct wages will increase by 10%.You are required to prepare- (a) Cost sheet for the year, 1995, showing various elements of cost per unit, and (b) Estimated cost and profit for 1996 assuming that 15,000 units will be produced and sold during the year. Factory overheads are recovered as a percentage of direct wages and office and selling expenses as a percentage of works cost. (Apply the same respective percentages as in the previous year.)10.A factory uses job costing method. The following cost data is obtained from its booksfor the year ended 3 1 st December, 1995 : Rs. Rs.Direct materials 1,80,000 Selling and distributionDirect wages 1,50,000 overhears 1,05,000Profit 1,21,800 Administration overheads 84,000 Factory overheads 90,000 (a) Prepare a job cost sheet indicating the prime cost, works cost, production cost, cost of sales and the sales value. (b) In 1996 the factory receives an order for a number of jobs. It is estimated that direct materials required will be Rs.1,40,000 and direct labour will cost Rs. 1,50,000. What should be the price for these jobs if the factory intends to earn the same rate of profit on sales assuming that the selling and distribution overheads have gone up by 15%? The factory recovers factory overheads as a percentage of direct wages and administration, selling and distribution overheads as a percentage of works cost, based on cost rates prevailing in the previous year.11.Following figures are extracted from the records of a Co. for the year 1994-95 Rs. Direct Materials 60,000 Direct Wages 50,000 53

Works Overhead 30,000 Administrative Overhead 33,600 Selling Overhead 22,400 Distribution Overhead 14,000 Profit 52,500One material had been manufactured and supplied to Mr. X, in 1995-96 for which thefollowing expenses were incurred Rs. Direct Material 4,000 Direct Wages 2,000In 1995-96 Works overhead was increased by 20%, Distribution overhead had beendecreased by 10% and Selling and Administrative overhead each were increased by12-5%.At what price the above supply is to be billed to Mr. X so as to earn the same rate ofprofit on selling price as earned in 1994-95.12.The following figures are available from the books of Best Manufacturing Co. for theyear ended 31.12.95 : Rs. Rs.Materials Profit for the year 6,090Stock on 1. 1.95 1,000 Selling overhead 5,250Stock on 31.12.95 2,000 Factory overhead 4,500Purchases during 1995 10,000 Administration overhead 4,200Wages 7,500 (a) Prepare a cost sheet showing prime cost, works cost, cost of production, cost of sales and sales. (b) In 1996 the factory receives an order for a job which will require materials Rs. 1,200 and wages Rs. 750. Ascertain the sale price of the job if the factory intends to earn a profit 10% higher than the percentage of profit earned in 1995. Assume that the factory overhead has gone up by 162/3% and selling overhead has gone down by 20% in 1996. Further assume that factory overhead is recovered as a % of the wages and administration and selling overhead as a percentage of works cost.13.The following particulars relating to the year 1992, have been taken from the books ofa chemical works, manufacturing and selling a chemical mixture: Kg. Rs. Kg. Rs. Stock on 1. 1. 1992 Salaries Raw materials 2,000 2,000 Factory 72,220 Finished mixture 500 1,750 Office 37,220 Factory stores 7,250 Selling 41,500 Purchases : Expenses: Raw materials 1,60,000 1,80,000 Direct 18,500 Factory stores 24,250 Office 18,200 Sales : Selling 18,000 Finished mixture 1,53,050 9,18,000 Stock on 31.12.1992 Factory scrap 8,170 Raw materials 1,200 ? Factory wages 1,78,650 Finished mixture 450 ? Power 30,400 Factory stores 5,550 54

Depreciation of machinery 18,000The stock of finished mixture at the end of 1992 is to be valued at the factory cost of themixture for that year. The purchase price of raw materials remained unchangedthroughout 1992.Prepare a statement giving the maximum possible information about cost and its break-upfor the year, 1992.14.From the Cost Ledger of B. K. Industries the following information was obtained forthe year, 1990 : Rs. Rs.Rates and taxes for factory Repairs and maintenance (plant) 20,000premises 2,800 Cost of rectification ofLighting of the factory 5,200 defective work 5,600Depreciation (plant) 7,000 Consumable stores 15,000Staff salaries 24,000 Selling expenses 14,660Management salaries 12,000 General expenses 9,200Power 9,000 Receipt from the sale of scrap 2,400Indirect wages 24,500 Profit from guest house 1,000Production was 1,00,000 units and the prime cost per unit was: - materials-Rs. l.80 andwages-Rs. 1-20. Me net selling price was Rs. 4.70 per unit. All the units were sold.As from 1st January, 1991, the selling price was reduced to Rs. 4.50 per unit. It wasestimated that production could be increased in 1991 by 50 per cent without incurring anyovertime or extra shift working.Prepare statements showing (1) Different elements of cost for 1990, (2) Estimated costand profit for 1991, assuming that 1,50,000 units will be produced and sold in the year.Assumptions made to solve the problem should be stated. 55

Cost accounting1

by Pankaj Kumar

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Cost accounting1 Document Transcript